October 2018 Investor Report

Published: October 25, 2018Updated: May 15, 2019

It was a very volatile
month for the stock market which saw a vast majority of equity sectors decline
in value. We witnessed a lot of selling very early in the month of October with
the S&P 500 and the Dow Jones giving up most of their year-to-date gains
within the first 14 trading days. Fortunately, our portfolios favor lower risk instruments
and therefore avoided much of this downside pressure. Being on the top of the
capital structure requires companies to pay us our interest payments (in the
case of bonds) and a contractual priority (in case of our preferred stock), so
we experience less volatility than common stock, which saw declines as much as ten
percent, as with the NASDAQ.

We continue to monitor the
Federal Reserve, which provided another interest rate increase in September and
is guiding toward another in December (with three more interest rate increases
forecasted in 2019). It was the release of the minutes from the September Board
of Governors Meeting that drove much of the decline in markets as it seems that
the Federal Reserve is committed to tightening monetary policy with 0.25
percent interest rate increases every 90 days. The Federal Reserve has
been the most hawkish of all the major central banks in the world for the last
two to three years. The prospects of a weaker dollar over the next year are
very real if the Federal Reserve continues to raise interest rates that choke
the economy of growth, accelerating the growing US government budget deficit
and debt. The President has been very outspoken about his concerns that the
Federal Reserve will continue to raise borrowing rates and hurt the stock
market and the economy alike. It is important to note that financial assets and
our economy have distinct, neutral interest-rates. Neutral interest rates will
be one of the major topics in next month‘s letter.

This will be our last
monthly letter before the midterm elections and investors are keenly following
how the results may alter the majorities in both houses of Congress. The latest
polling suggests that Democrats may take a majority in the House of Representatives,
while Republicans will keep the Senate. If the Democrats take either chamber on
Capitol Hill, this could disrupt the Trump Administration’s policy agenda and
further unsettle equity markets. The US was the only major economy to enjoy a
tax cut in the last 12 months. The response was widespread stock buybacks,
which created a short-term, material increase in demand for stocks. This
deficit increasing fiscal plan (the tax cut) is the major reason why the US equity
markets are outperforming the rest of the world. We have seen a lot of weakness
around the world. For example, the Shanghai Composite Index is near a two-year
low, and down 25 percent year-to-date. In combination with the ongoing
trade talks and tariff battle with United States, China should be one of the
major points of interest going in to 2019.

Please review the following updates from some of the existing
positions that we manage:

Scorpio Bulkers (SLTB)
– On October 22nd, SLTB company reported strong third quarter earnings. It announced
record high levels of EBITDA at $28.8 million for the quarter. This provides
great momentum the remaining 11 months of the company’s bonds that we own. We
are actively watching this bond for an opportunity to get a good interest rate
for such a short period of time. The bond is currently callable and trading
above par, and we do not want to recklessly purchase the bond at any price.

TPG Specialty
Lending Stock (TSLX) – This common stock is held in our moderate investors’
portfolios and has been a good performer over the 90-120 days that we held it. On October 8, TPG’s received shareholder
approval to lower its minimum asset coverage ratio to 150 percent. We have
spent time in the monthly letters discussing how we were going to keep an eye
on BDCs that move to this new regulated leverage limit. As of now, we are going
to hold the position but will continue to evaluate it over the next 30 days. We
believe the company will report strong third quarter numbers and will look to
use those strong quarterly figures to exit the investment.

PHI Bonds maturing
March 2019– We sold out of our
remaining bonds after the tender offer was terminated by management in the
middle of the month. This was a disappointing outcome as PHI had the
refinancing for our bonds lined up but chose not to take the $600 million that
was raised because the debt was deemed to be too expensive. Instead they chose
to start a process to sell a part of the company. In the meantime, the Chairman
and CEO bought out the company revolver with his own money making him the top
of the capital structure. We were surprised that management would walk away
from financing during these tough times in capital markets. We are skeptical
that PHI will be able to negotiate and finalize the sale of its subsidiaries
before the March 2019 maturation deadline. We simply do not want to take the
risk of a possible bankruptcy if capital markets deteriorate between now and then.